‘Flash crash’ and reform

Traders work on the floor of the New York Stock Exchange Monday, April 20, 2015. (AP Photo/Richard Drew)

Questions about the sluggish response of the nation’s top security regulators to the causes of the May 6, 2010, “flash crash” of American stock markets highlight the need for a new look at financial markets regulation.

The flash crash temporarily wiped trillions of dollars from the value of stocks. A rapid rebound limited real losses. But the instability demonstrated by the event has raised a major concern about the integrity of American securities markets.

Nevertheless, it has taken nearly five years for federal regulators to bring charges alleging illegal market manipulation. The question is why it took so long when the data were available within days of the event. Lack of effective oversight seems to be the chief reason.

Apparently, the case fell between the cracks of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The trading at issue was in stock futures, which either agency could supervise.

On April 21 the Justice Department at last brought 22 charges against a British trader working from his parents’ home in a modest London suburb. An investigation by the CFTC said the trader, 36-year old Navinder Singh Sarao, “was at least significantly responsible for the order imbalances” in the derivatives market which affected stock markets. Mr. Sarao was charged with placing “$200 million worth of bets that the market would fall” and rapidly altering them 19,000 times before they were cancelled.

False orders to buy or sell, placed in the futures market, are known as “spoofs” and are currently illegal. Mr. Sarao allegedly used High Frequency Trading (HFT) software to place and modify his bets. The fact that a single “day trader” could allegedly wreak such havoc is a signal that markets remain vulnerable and require better oversight. Mr. Sarao, who reportedly made $40 million, is fighting extradition to the United States.

The Justice Department acted against him just a day after a committee of senior financial experts known as the Volcker Alliance issued a report calling for reorganization and consolidation of the federal agencies responsible for overseeing financial markets.

The Volcker Alliance was founded by former Chairman of the Board of Governors of the Federal Reserve System Paul Volcker, a consistent and vocal critic of the shortcomings of federal financial system oversight.

In comments on the proposals, which include merging the SEC and CFTC, Mr. Volcker wrote, “The structure that failed us in anticipating and responding to the [2007-2008 financial] emergency is largely still in place.... As a result, what we see in full view are inconsistencies in approaches among the half-dozen or more regulatory agencies, differing priorities, overlaps and gaps, squabbling over turf, incentive for competition in lax regulation; and too many opportunities for agency ‘capture’ by those regulated.”

The Volcker Alliance proposed a specific reorganization of federal financial oversight, recognizing that existing systems date from the 1930s and are clearly not up to the challenges of the 21st century.

Others have proposed even more radical simplification of financial oversight on the argument that complex rules are more easily gamed and evaded.

The flash crash case highlights the need for serious restructuring of the systems for state, national and international financial oversight. Economic security may depend on it.